Resolving the North American Subsidies War

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July 1996

Resolving the North American Subsidies War

An edited version of the paper was published as an issue of Canadian-American Public Policy (Number 27, September 1996)

Peter Morici*

I. Background

In negotiating the Canada-U.S. Free Trade Agreement (FTA), a critical objective for both sides was to defuse and better manage the difficult issues surrounding industrial and regional development subsidies and the application of countervailing duties.
During the 1960s and 1970s, Canadian federal and provincial governments became increasingly engaged in activist policies, which included incentives to improve the competitiveness of manufacturing and foster development in the Atlantic Provinces, the Gaspe and rural areas elsewhere.1 When U.S. business and/or labor interests were adversely affected, the United States often responded with countervailing duties.2
Part of a broader offensive against what they saw as unfair trading practices, the scope of actions targeted by the Americans gradually expanded from explicit export subsidies to domestic production subsidies and then R&D grants for the development of specific products.3 Most significantly, the United States assessed countervailing duties on regional assistance to a Michelin tire plant in Nova Scotia in 1973, and it countervailed a Canadian product development subsidy for a Liquid Optic Sensing Device in 1979.4
Canadians and other U.S. trading partners did not view the application of countervailing duties by the United States as wholly objective, and perceived its actions as part of an expanding system of U.S. contingent protection.5 In the FTA negotiations, Canada initially sought a working definition of what constituted a prohibited subsidy and exemption from U.S. countervailing duties and other forms of contingent protection.
During the 1970s, the U.S. federal government too engaged in a variety of industrial assistance programs. Aids to the steel, footwear, textile, shipbuilding, automobile, and aircraft industries6 followed the emergence of an activist regional agenda during the Great Depression and the Johnson Administration in the 1960s.7
Following the elections of Ronald Reagan in 1980 and Brian Mulroney in 1984, federal aids to enterprises declined in both countries, and the locus of initiative in industrial and regional policymaking--outside of agriculture, R&D and defense technology--shifted somewhat toward the states and provinces.
In Canada, the necessary apparatus was already quite well developed, as the provinces had long been active.8 In the United States, increasing concerns about the international competitive competence of American manufacturing, Reagan Administration agnosticism toward industrial policies, the dominance of the Democratic Party in most state houses, and a consensus within the Democratic Party that governments could and should play a positive role in economic development combined to impel more aggressive state programs.9
Although not all provincial and state programs may be characterized as trade distorting and inefficient, at least some of what goes on cannot be justified on economic grounds. However, tailoring packages of benefits and services to keep or attract manufacturing enterprises falls squarely in the latter category.10
As things stood at the dawn of the FTA negotiations in 1986, the primary concerns were the fair application of subsidy/countervailing duties by competent authorities in the United States and Canada and the costly competition among the states and provinces for plants. The optimal outcome would have been: (1) a strong discipline defining what federal, state and provincial governments could and could not do to keep and attract businesses; and (2) refinements in existing countervailing duty administration that would ensure confidence in the fairness of actions involving programs and benefits that neither fell in the permitted or prohibited categories.
Although both Americans and Canadians said they wanted a discipline on the use of subsidies, two problems constrained negotiators. First, it would be difficult for the United States to accept a meaningful bilateral discipline that would affect 100 percent of its exports but only one fifth of its imports, which come from Canada.11 Second, Washington and Ottawa have strong political reasons to tread carefully when seeking constraints on the economic activities of the states and provinces.12 In the end, FTA negotiators settled for half a loaf. FTA Chapter 19 established binational review of subsidy/countervailing duties to ensure that national laws are being faithfully applied, free from political interference and technical errors.
When the FTA was inaugurated in 1989, this mechanism was intended as a stop gap--the FTA committed the two governments to negotiate a truly binational subsidies regime within five to seven years. These negotiations never got off the ground, as the principals agreed to await the outcome of the Uruguay Round subsidy talks where a strengthening of the General Agreement on Tariffs and Trade (GATT), multilateral discipline was under discussion. In the meantime, Mexico requested free trade talks, and the North American Free Trade Agreement (NAFTA), implemented in 1994, essentially made permanent the FTA system of binational review--the relevant FTA and NAFTA chapters are both numbered "19."13
Although FTA and NAFTA Chapter 19 did inspire more confidence in the integrity of national subsidy/countervailing duty administration, the problem of locational incentives and state/provincial industrial predation continued. A multilateral solution under the auspices of the new World Trade Organization (WTO)14 could overcome the two obstacles noted above: the United States could agree to limit the benefits it bestows on all of its exports in exchange for similar constraints on the subsidies offered by most of its significant foreign competitors; the substantial benefits to be achieved by curbing European and Asian subsidies, as well as from a broad multilateral trade agreement, might provide Washington and Ottawa with enough leverage to persuade state and provincial governments to accept an armistice, or at least new rules of engagement, in the North American Subsidies War.
The Uruguay Round Subsidies Code15 implemented in 1995 will provide some discipline on actions of states and provinces; however, when seen in the context of contemporary patterns of subnational subsidies and industrial organization, this new code is unlikely, by itself, to provide a satisfactory solution for U.S.-Canadian trade.
After the drafting of the Uruguay Round Subsidies Code was completed, the United States, Canada and Mexico undertook additional negotiations as required by NAFTA Chapter 19. Although the final report has not yet been released; it will only contain adjustments and marginal improvements in current regime. This is truly unfortunate. The adjustments imposed by corporate downsizing, new technologies and the shift of labor-intensive activities to low-wage locations are only intensified by NAFTA and the Uruguay Round Agreements (implemented in 1995), and subnational governments continue to labor under relentless pressures to defend their employment bases by offering special benefits to multinational corporations. The United States and Canada could craft a solution that is consistent with, but goes beyond, the Uruguay Round Subsidies Code.
The European Union (EU) has such a mechanism to deal with virtually all kinds of subsidies offered by national and subnational governments that may affect intracommunity trade; however, it entails more reliance on supranational authority in the form of EU Commission intervention than the Congress and Parliament are likely to accept. Nevertheless, the EU systems has some desirable characteristics that could be adapted by the United States and Canada. In the end, a discipline that focuses primarily on special incentives to attract mobile corporate capital and technological knowhow, coupled with an enforcement mechanism that acknowledges the inherently political and noneconomic nature of decisionmaking in this realm, may prove the best compromise available.
The remainder of this paper is divided into four parts. Part II briefly describes the regime prior to the implementation of the Uruguay Round Subsidies Code--the Tokyo Round Subsidies Code, FTA/NAFTA Chapters 19 and patterns of national and subnational industrial policy. Part III examines how the Uruguay Round Subsidies Code will likely affect national, state and provincial practices. Part IV briefly describes the EU regime. With this as background, Part V suggests a way to fashion a supplemental U.S.-Canadian subsidies regime, which is consistent with the draft Uruguay Round Subsidies Code and potentially could be incorporated into NAFTA to include Mexico.

II. The Pre-Uruguay Round Situation

Both the United States and Canada had empowered administrative authorities to respond to private sector complaints of harm from subsidized imports. Prior to the Uruguay Round Agreements, legislation in both countries was consistent with the requirements of the GATT and the Tokyo Round Subsidies Code implemented in 1980.16 Together national laws and GATT rules sewed together a so-called red, yellow and green regime.17
The Tokyo Round Code prohibited export subsidies by developed countries, with the exception of unprocessed farm, fish and forest products (red-light subsidies). Domestic production subsidies were permitted but actionable. While explicitly recognizing their utility as instruments of domestic economic development policy, the Code permitted importing countries to impose countervailing duties if foreign-subsidized imports materially injured a domestic industry (yellow-light subsidies). U.S., Canadian and EU law defined generally available domestic subsidies--for example, a loan program available to all small businesses--as nonactionable (green-light subsidies), and U.S. trading partners wanted to see this concept incorporated into, and expanded in, the Uruguay Round Subsidies Code.18
During the 1980s, industrial policies in both the United States and Canada underwent dramatic transformations for several reasons. First, as noted above, the more conservative tone of the Reagan/Bush and Mulroney governments resulted in more reluctance by the two federal governments to assist mature industries and seek employers for depressed regions. Second, a consensus emerged about the need for greater federal involvement in precompetitive research.19 Third, policymakers became increasingly aware that small- and medium-sized firms faced difficulties in commercializing technologies, even when they already had the knowhow in hand. This was viewed with some alarm, because such firms are often the wellspring of many highly innovative products and new jobs. Fourth, it became widely documented that the gap between North American and Japanese firms in the application of the latest manufacturing process technologies was most acute among second-tier firms--although firms like Chrysler and Ford had their problems, things were much worse among their suppliers.20
In the United States, a partial, informal federal-state division of labor emerged. At the federal level a more focused, even if less well funded, array of programs grappled with the problem of supporting precompetitive research and encouraging the kinds of industry cooperation that had proven so productive in Japan; the states were left to wrestle with the vexing problems of depressed communities and the shrinking base of manufacturing jobs paying high wages for fairly ordinary labor; and both levels of government sought ways to assist small- and medium-sized firms in commercializing new technology and learn new manufacturing methods.
Although President Reagan drastically cut funding for the Economic Development Administration, Small Business Administration and similar programs during his first term,21 a number of efforts emerged during his second term that increased federal involvement in commercial technology and manufacturing extension services to small- and medium-sized firms. Specifically, in 1985, the federal government established 18 Engineering Research Centers on university campuses to encourage academic researchers to focus more on commercial allocations; in 1986, the federal government took the lead in establishing the Sematech consortium, which develops advanced chipmaking technology, and it created the National Center for Manufacturing Sciences (NCMS),22 which established teaching factories in St. Louis, Toledo, and Huntington, West Virginia. In 1988, the National Institute for Standards and Technology (NIST), within the Department of Commerce, inaugurated the Advanced Technology Program to help finance precompetitive research,23 and NIST established five Manufacturing Technology Centers24 (MTCs) to provide extension services to small- and medium-sized firms.25
By the time President Bush took office an institutional infrastructure had been assembled from which to launch activist support for precompetitive research and technology transfers to the small- and medium-sized firms. However, industrial policy turned out to be one of the few areas where the President Bush was more conservative than President Reagan. Although these programs sound ambitious, the Bush Administration sought to deemphasize them,26 and its budgets never adequately funded them. For example: U.S. industry received little support, other than antitrust neutrality, in efforts to replicate Sematech in other areas;27 within the federal bureaucracy efforts to capitalize on the storehouse of commercially exploitable knowledge in defense and energy laboratories remained unorganized; and although two more MTCs were established, adequate geographic coverage would have required many more centers.
In contrast, the incoming Clinton Administration was much more committed to moving forward with federal support for precompetitive research, industry consortiums and technology transfer to small- and medium-sized businesses.28 For example, it substantially increased funding and sought innovative and activist leadership for the Advanced Technology Program. NCMS planned to substantially increase the number of teaching factories29 and NIST was seeking to dramatically increase the network of MTCs.30 A new federal activism, quietly envisioned by Mr. Reagan and shunned by Mr. Bush, was to be actualized by Mr. Clinton.
With the election of more-conservative, Republican Congress in 1994, most of these initiatives were downsized or shelved. The Advanced Technology Program has been a particular target of Congressional budget cutters,31 and the rising contribution of U.S. exports to the recent economic recovery has quelled concerns about U.S. competitiveness.32 Nevertheless, interest in industrial policy at the federal level has ebbed and flowed for several decades, and the continued efforts of state governments (described below) indicate that public support for industrial policy in state houses remains substantial. The Reagan and Clinton frameworks provide an important indication of the likely characteristics new federal initiatives when interest reemerges in a federal industrial policy.
In Canada, Brian Mulroney reduced the subsidies offered by Canada's general economic development programs. Ottawa continued to provide some support for R&D and technology transfer but Canada's programs never matched the systematic focus that the Reagan and Clinton Administrations sought to shape. Were interest in industrial policy to reemerge in Washington, the Government of Prime Minister Jean Chretien would face substantial political pressure to respond in kind.
During the 1980s, the U.S. states sought to fill the void created by the contraction of general federal regional and industrial development programs with their own efforts to attract industry33 and strengthen already established locally-based companies. The means included: various tax incentives and holidays, grants, equity participation, loan programs, provision of utilities and other amenities at attractive prices, a variety of R&D aids and technical assistance, manpower training assistance, and efforts to make public education--in particular, vocational education--more responsive to the needs of employers. In Canada, the provinces had already had established a rather extensive array of programs in the 1970s,34 which became more prominent with the contraction of general federal programs in the 1980s. In the 1990s, these activities continue at even in an era of severe fiscal constraints.
How much of this is good or bad? As a starting point, virtually all observers would agree governments have some responsibility for preparing citizens for work and helping firms overcome market failures. It is difficult draw precise lines, for example, between appropriate public support for vocational education and training grants to enterprises that merely subsidize their operating costs. In the United States, community colleges and technical schools often have proven ill-equipped to prepare blue collar workers for new manufacturing environments, and the work place is often the best place to impart marketable skills to new hires and displaced workers. Similarly, market failures are often the root cause of out-of-date methods among small firms, and this is the basic justification for modeling manufacturing extension services after the successful systems of agricultural extension services.
For our purposes state and provincial activities may be divided into two categories: programs that improve the quality of less-mobile, local resources and more targeted packages of benefits assembled to keep or attract mobile multinational corporate capital. Both macroeconomic and industrial/regional policies can be applied to these purposes.
In recent years, state industrial policies have increasingly focused on technology and training. For example, the Ohio Thomas Edison Program and the Pennsylvania Ben Franklin Program bring together universities and private firms in commercial R&D projects. Both programs assist entrepreneurial companies commercialize technology. Also, the Pennsylvania program assists established manufacturers adopt new technology through four regional Advanced Technology Centers, and the state has established eight non-profit corporations providing similar services.35 A 1991 Congressional study found that 16 states offered in-plant extension services, and another 7 had established walk-in programs.36
Many states have aggressive manpower training programs that help employers find blue-collar workers with skills not generally found among new hires. For example, Illinois provided firms with assistance exceeding $25 million per year in 1991 through its Industrial Training Program, and a program bearing the same name in Ohio spent about $6 million in 1990.
Extension services and manpower programs are frequently tailored to the needs of local industry. For example: the Wichita Kansas and Sedgwick County Partnership for Growth was established to bring together government and private sector resources and the Institute for Aviation and Composite Materials Laboratory at Wichita State University to help small suppliers of companies like Cessna, Beech Aircraft, Gates Learjet, Boeing and others implement state of the manufacturing systems;37 the NIST MTC in Cleveland established an outreach center at Youngstown State University, with the assistance of state resources, to focus on aluminum extrusion (and the tool and die makers that supply this industry) as a way to revive a steel-based local economy.38 To attract three computer chipmaking factories to Virginia the state is contributing $10.5 million to worker training, and has pledged $20 million for higher education to improve training for engineers and technicians at state universities and community colleges.39
The central objective of these kinds of programs is to help firms and workers improve their skills and compete--make the pie bigger instead of fighting over who gets the biggest slice. When not overdone, they are a far cry from the direct competition for a new Ford or Mercedes-Benz plant. However, in some instances, states and provinces steer benefits from general programs to complement specially legislated tax breaks and benefits when they build packages to keep and attract plants--Virginia commitments to education and training noted above fall into this category. Overall, the practice of combining special measures and steering benefits from generally available programs has become a high stakes competition for factories and jobs.
In the automobile sweepstakes winning packages have included: Ohio - Honda at East Liberty and Marysville; Tennessee - Nissan at Smyrna; Kentucky -Toyota at Georgetown; Illinois - Diamond-Star at Normal and Bloomington; Ontario - Honda at Alliston and Ford at Windsor; and Quebec - General Motors at St. Therese. In 1992, for example, the South Carolina legislature approved an estimated $150 million in tax breaks and other benefits to attract a BMW plant including a $1,500 per employee state income tax credit, concessions on water and sewage, funds to buy and prepare the plant site, and 55 free apartments in Greenville and Spartanburg.40 In 1993, Alabama outbid South Carolina and North Carolina with an estimated $300 million package for a Mercedes-Benz plant, which included state payment of the salaries of 1,500 workers during their first year or so on the job.41
In the aerospace sector, Ontario took a 49 percent equity stake in de Havilland and teamed up with the federal government to offer a Cdn.$490 million in financial assistance package to rehabilitate the troubled aircraft company.42 In chipmaking, Virginia has attracted three major plants--IBM/Toshiba in Motorola/Siemens and Motorola--to locations near Richmond and Northern Virginia. In addition to the employment training commitments noted above, the state has offered grants and tax benefits bring the total cost of these packages to $154 million.43
A 1996 KPMG Peat Marwick survey of 203 Fortune 1000 companies found that 160 had received some kind of state or local incentive for locating facilities in particular jurisdiction. Leading the list of perks were: property tax rebates - 51 percent; income and franchise tax rebates - 48 percent; sales tax rebates - 35 percent; job training - 11 percent; employment or payroll tax credits - 9 percent; utility rebates - 8 percent.44
Absent a truce in this competition, state and provincial governments are under considerable pressure to participate. Apparently, they perceive the net impact on tax revenues of individual incentive packages on jurisdiction winning or keeping employers to be positive, while the net impact on the tax base of losing jurisdictions to be negative. The more successful states, such as South Carolina and Virginia, have increased their employment and tax bases, while the less successful ones have suffered severe loses.45
The consequences of this competition for the distribution of the tax burdens among interest groups and for regional economic disparities are difficult to defend. State and provincial incentive packages probably have few consequences for the choice of firms to locate or stay in the United States and Canada; hence, they have little impact on the overall size of manufacturing tax base and employment within the free trade area. However, these practices reallocate the tax burden from highly mobile corporate capital to less mobile local capital and labor; they tend to favor wealthy jurisdictions at the expense of poorer ones. Although these incentive packages benefit the workers directly employed by transplants and the communities in which they locate, overall, the North American Subsidies War has two perverse effects: it redistributes after-tax income to multinational corporations, who are often foreign, from less-mobile, small businesses and workers; and it tends to exacerbate regional disparities in income and employment opportunities.
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